Why You Shouldn’t Overpay for Market Beta

Market benchmarks representing the same segments are essentially interchangeable

Apr 30, 2018

Dan Lefkovitz

Think back to February, when volatility roiled long-placid equity
markets. Stocks plummeted early in the month, then bounced back,
before ending down. How did various equity market benchmarks gauge the
volatile month?

The market benchmarks displayed above vary in their methodologies
and index parameters. Some target the higher end of the market, while
others are comprehensive. Some use a fixed constituent count system;
others capture a percentage of market value. But thanks to the
commonly applied market capitalization weighting approach, these
indexes delivered nearly identical returns in February 2018.

While strategic beta indexes can carry enormous complexity, market
benchmarks are commoditized. Investors can reduce their costs, and
thereby improve their outcomes, by paying as little as possible for
market beta.

Market benchmarks: The Vanguard precedent

“There were three main reasons for this change and its cost, cost,
and cost,” said Vanguard executive Joel Dickson in a 2012 video interview for
Morningstar.com®. He said Vanguard was reacting to rising
index licensing fees, which represent an ever-larger percentage of
index-tracking funds’ expense ratios.

As a firm owned by his fund holders, Vanguard constantly looks for
opportunities to cut costs and pass along savings. “Through a series
of best practices that most of the index providers have converged to
over the years, the differences between a lot of providers are
relatively small,” Dickson said.

This observation was echoed by a 2016 paper published by the Spaulding Group in
conjunction with BNY Mellon, State Street, and Northern Trust: “There
is minimal difference between several index providers that serve the
U.S. and global equity markets in terms of performance; while
methodology varies among indexes, those variances are largely tempered
by capitalization weighting.”

Market benchmarks are interchangeable: A case study

The interchangeability premise is borne out in the following
comparison. The Russell 1000 Index and the Morningstar US Large-Mid
Cap Index look remarkably similar from both returns-based and
holdings-based perspectives.

Morningstar Open Indexes Project

The paradox of rising index costs at a time of downward fee
pressure in the asset management industry drove Morningstar to act in
2016. Inspired by the concept of open source software, Morningstar
launched a disruptive initiative to make benchmarking more accessible.

Morningstar research has demonstrated repeatedly over the years
that fees are a significant driver of relative performance. Lower-cost
investments possess an inbuilt advantage. Because index licensing fees
are ultimately passed along, the lower the costs of benchmarking, the
better the investor experience.

Read the full research paper “Market Beta is a
Commodity. Don’t Overpay.”

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